What’s the optimal amount of home-country (currency) bias?

I have the view, which I consider fairly obvious but not always clearly articulated, that virtually all low-enough-cost, adequately-diversified investments will yield positive nominal returns over the appropriate investment time horizon. If you own yen-denominated Japanese bonds, you should expect to receive a positive yen-denominated return over the term structure of the bonds. If you own euro-denominated stocks, you should expect to receive a positive euro-denominated return over the (potentially infinite) time horizon of your equity investments.

There are exceptions. If you’re a yen-denominated investor who inherited a fortune on December 31, 1989 and immediately invested it in a Nikkei 225 index fund (I’m not sure such a thing existed at the time, but bear with me), then even with dividends reinvested your fortune today would still be somewhat smaller in yen than it was on that date. Likewise communist upheavals and sovereign defaults have completely wiped out bond investors at various intervals around the world.

Diversification is a sensible way to secure part of the return of various global assets classes with unknown (but presumably positive) nominal growth, while reducing the risk of total loss in case of war, communism, or default. It is so sensible, in fact, that I think people can get a bit too enthusiastic about its merits. That’s because diversifying internationally reduces your concentration risk but adds a new risk, currency.

If yen-denominated assets rise by 6% a year but the yen declines by 6% per year against the dollar, you’ll enjoy positive yen-denominated returns but flat dollar-denominated returns. That’s a big deal if you plan to retire to a country that sells goods and services in dollars!

Home country bias

“Home country bias” refers to the tendency of investors to allocate a disproportionate amount of their capital to domestic assets. That begs the question, “disproportionate” compared to what? To say an investor allocates “too much” capital to a given country implies there’s also a correct amount to be allocated there.

Two ways you might define an “unbiased” asset allocation are by the market capitalization of a country’s investable securities, or the share of global economic activity in a given country. A market capitalization approach has the advantage of automatically rebalancing over time as markets rise and fall in value, while an economic activity-weighted allocation would need to be manually rebalanced since a country’s rising or falling share of economic activity may or may not be reflected in its market capitalization.

A market capitalization-weighted portfolio would hold about 36% in US equities and 64% in international equities, while an economy-weighted portfolio would hold somewhat less in US equities, perhaps 25%. If you hold more US equities than whichever you think is the “real” benchmark, then congratulations, you have home country bias!

It makes sense to be overweight the currency you intend to spend

Most people, in most of the world, are born, grow up, and die in the same country. That means most people’s income and expenses are denominated in the same currency.

This general rule is not, however, universally observed. While I was there, Russian banks offered certificates of deposit denominated in rubles, dollars or euros, with different interest rates depending on the currency you chose (ruble deposits paid the most). Likewise in Europe we recently saw the revaluation of the Swiss franc punish Polish homebuyers whose income is denominated in zloty but who took out franc-denominated mortgages to take advantage of lower interest rates.

If international diversification is a way to reduce the risk of concentrated bets on a single country, then home country bias is a way to reduce the risk of exchange rates moving against you. Most large-country exchange rates are mostly stable most of the time. But as the Poles learned, you also don’t want to be left holding the bag if the currency you intend to spend suddenly gets much more expensive.

What this logic means is that you should be biased not towards your home country, or even your home currency, but rather the currency where you intend to spend the value of your investments — and you can be biased towards different currencies for different reasons!

For example, a 529 plan you intend to liquidate to pay for an education in the US might be biased towards US stocks and bonds, while a retirement account you intend to use to retire in the Eurozone might be biased towards euro-denominated stocks and bonds. In the one account you’re protecting yourself from a stronger dollar, which would raise the price of US higher education in non-dollar-denominated assets, while in the second you’re protecting yourself from a stronger euro.

What’s the optimal amount of home-currency bias?

The funny thing about home-currency bias is that it tends to provoke absolutism in people. If you believe that home-currency bias is an investor “error” and that it should be eliminated completely, you arrive at the strange view that everyone in the world should have the same asset allocation (at least within their stock and bond “buckets”). A Greek, Chinese, Polish, Canadian, Ecuadorean, and US investor should all hold 36% of their stocks in a market-cap-weighted US mutual fund and 64% in a market-cap-weighted international fund.

On the other hand, Jack Bogle’s view has long been that international investing is unnecessary for US investors. US companies do business all over the world, so you get the same currency and economic risk exposure you would get by investing in international companies directly.

I think the right answer is not 100% home-currency bias or 0% home-currency bias, but rather the terribly unsatisfying “some home-currency bias.” To the extent that your future expenses are predictable, shading your asset allocation to the currencies those expenses are denominated in makes perfect sense. If you have a Swiss franc-denominated mortgage, you should be “overweight” franc-denominated assets (or save up several years worth of mortgage payments in francs). If you plan to send your kids to US colleges, you know for a fact those expenses will be high and dollar-denominated, so logically those savings should be overweight US dollars.

What if you can pick the currency your expenses are denominated in?

So far I’ve been talking about future expenses that are denominated in a known currency. You know as soon as you sign the paperwork what currency your mortgage payments will be in, and US colleges and universities only accept US dollars. But not all expenses are like that, or at least they don’t have to be. You don’t have to decide which currency to retire in until you’re ready to retire. Then you can consult the latest edition of the Economist’s Big Mac index and move to the country with the most undervalued currency.

To the extent that you can pick the currency your retirement expenses will be denominated in, then your goal should logically be to maximize the dollar-denominated value of your portfolio (the one that appears on your statement). If the dollar falls in value, you can stick around in the US where our goods and services are dollar-denominated, while if it rises in value, you can pick the retirement destination of your choice. In that case, you really might want to eliminate home country bias in your equity portfolio because you aren’t exposed to the same exchange rate risk.

You can apply the same logic to education expenses. If international institutions get cheaper in dollar terms, you can ship your kids overseas, while if they get more expensive, well, US colleges will continue to accept your worthless dollars.

Conclusion

One reason it’s hard to think clearly about currency risk is that if you work with a US brokerage, your account’s value is only shown to you in US dollars, so it’s difficult to keep in mind that the value of your portfolio can rise in dollars while falling in another currency (if that currency appreciates relative to the dollar), and vice versa.

Obviously anybody can look up current exchange rates and calculate the euro-denominated, ruble-denominated, or zloty-denominated value of their portfolio whenever they want, but I have long though it would be a cool feature for a brokerage to automatically calculate and display your account’s value and its change in value in 3 or 4 major currencies.

I know my portfolio’s value has risen in US dollars, and I know the US dollar has fallen compared to the Swiss franc. Which effect is larger? Have I grown wealthier or poorer in Swiss francs? I think that would help people think more clearly about currency risk, and perhaps even improve their ability to design an investment portfolio that targets returns in the currency they actually intend to spend.

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